Value add investment strategies aim to generate excess returns over a benchmark by making active investment decisions. Investors pursuing these strategies believe they can outperform passive index funds by overweighting undervalued assets and underweighting overvalued assets. This requires thoroughly researching potential investments, identifying mispricings, and continually monitoring the portfolio. Value add investors may adjust sector weightings, individual security selection, geographic allocations and other factors. However, value add strategies also carry greater risks than passive strategies. Investors must have a high degree of conviction in their security analysis and portfolio management skills to justify the increased research and trading costs. Additionally, there is no guarantee that active decisions will pay off, and these strategies may underperform at times.
Value add strategies require identifying mispriced securities
The key to value add investing is finding assets trading below their intrinsic value. This requires rigorous research into factors such as cash flows, growth prospects, quality of management and relative valuations. Investors must determine if current prices fully reflect all available information on an asset’s fair value. Securities can become mispriced for various reasons – lack of coverage, overreaction to short-term issues, or market inefficiency. A value investor aims to exploit these mispricings before the market corrects the price. However, the investor must have a reasonable degree of confidence that their estimate of intrinsic value is more accurate than the market’s current assessment.
Portfolio management and monitoring are critical for value add strategies
Simply identifying undervalued securities is not enough. Value add investors must determine the appropriate size of positions to take in each security based on upside potential versus downside risks. They must also manage macro factors and asset correlations to ensure proper diversification within their portfolio. Ongoing monitoring of fundamentals and price movements is critical. The investor may need to adjust position sizes or sell out of positions entirely as initial assumptions change. Value add strategies require continually evaluating whether securities remain relatively underpriced compared to the rest of the portfolio.
Value add strategies can increase risks compared to passive investing
Passive index funds provide broad diversification and low fees but simply match the performance of a market benchmark. In contrast, value add strategies require more active trading, research costs and reliance on the investor’s skill in security analysis. This can potentially lead to underperformance, especially in efficient markets or periods when macro factors dominate security-specific fundamentals. Value add investors must weigh the potential for excess returns against the risks of poor security selection, higher costs and taxes. Additionally, concentrated bets on a small number of securities increases idiosyncratic risks compared to a broad index.
Value add strategies may be suitable for investors with specialized expertise
Given the additional risks and costs involved, value add strategies are best suited for institutional investors or individuals with specialized expertise in a particular asset class. For example, a real estate investment firm may possess unique local knowledge enabling it to identify properties trading below intrinsic value. However, for the average individual investor with a long-term horizon, passive index funds may provide higher risk-adjusted returns net of fees and taxes. Ultimately, the viability of value add strategies depends greatly on the manager’s competence in identifying mispriced assets and constructing optimal portfolios.
Value add investment strategies aim to outperform benchmarks by exploiting mispriced securities through active management decisions regarding asset allocation, security selection and portfolio monitoring. However, this requires accurate valuation analysis, strong risk management skills and tolerating potential underperformance. Value add strategies involve more costs and risks than passive indexing, so investors must carefully evaluate their qualifications and temperament for active management before pursuing this approach.